NELSON MANDELA – SOUTH AFRICA
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Chapter 12
Structure of
Central Banks
and the Federal
Reserve System
Introduction of the Federal Reserve System
• Central banks are very important
players in financial markets in the
world.
• Central banks affect interest rates,
amount of credit, and the money
supply.
• How does the central bank work?
Who controls the central bank?
• We will focus on the Federal
Reserve System, the most
important central bank in the world.
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Origins of the Federal Reserve System
• Resistance to establishment of a central bank
 Fear of centralized power
 American distrust of moneyed interests
• First U.S. experiments with a central bank terminated
in 1811 and in 1836
• No lender of last resort
 Nationwide bank panics on a regular basis
 Panic of 1907 so severe that the public was
convinced a central bank was needed
• Federal Reserve Act of 1913
 Elaborate system of checks and balances
 Decentralized system of banks throughout the US
 Power distributed between private and public
sectors
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Federal Reserve Banks
• Partly a public institution owned by private commercial
banks in the district that are members of the
Fed system
• Member banks elect six directors for each district;
three more are appointed by the Board of Governors



Three A directors are professional bankers
Three B directors are leaders from industry, labor,
agriculture, or consumer sector
Three C directors appointed by the Board of
Governors are not allowed to be officers,
employees, or stockholders
of banks
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Federal Reserve Banks (cont’d)
• Member banks elect six directors for
each district; three more are appointed
by the Board of
Governors (cont’d)

Designed to reflect all constituencies
of the public
• Nine directors appoint the president of
the bank subject to approval by Board of
Governors
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Functions of the Federal Reserve Banks
• Clear checks
• Issue new currency
• Withdraw damaged currency from
circulation
• Administer and make discount loans to
banks in their districts
• Evaluate proposed mergers and
applications for banks to expand their
activities
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Functions of the Federal Reserve Banks
• Act as liaisons between the business
community and the Federal Reserve
System
• Examine bank holding companies and
state-chartered member banks
• Collect data on local business conditions
• Use staffs of professional economists to
research topics related to the conduct of
monetary policy
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Federal Reserve Banks
and Monetary Policy
• Directors “establish” the discount rate
• Decide which banks can obtain discount loans
• Directors select one commercial banker from
each district to serve on the Federal Advisory
Council which consults with the Board of
Governors and provides information to help
conduct monetary policy
• Five of the 12 bank presidents have a vote in
the Federal Open Market Committee (FOMC)
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Member Banks
• All national banks are required to be members
of the Federal Reserve System
• Commercial banks chartered by states are not
required but may choose to be members
• Depository Institutions Deregulation and
Monetary Control Act of 1980 subjected all
banks to the same reserve requirements as
member banks and gave all banks access to
Federal Reserve facilities
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Board of Governors
of the Federal Reserve System
• Seven members headquartered in
Washington, D.C.
• Appointed by the president and confirmed by
the Senate
• 14-year non-renewable term
• Required to come from different districts
• Chairman is chosen from the governors and
serves four-year term
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Duties of the Board of Governors
• Votes on conduct of open market operations
• Sets reserve requirements
• Controls the discount rate through “review and
determination” process
• Sets margin requirements
• Sets salaries of president and officers of each
Federal Reserve Bank and reviews each
bank’s budget
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Duties of
the Board of Governors (cont’d)
• Approves bank mergers and applications
for new activities
• Specifies the permissible activities of
bank holding companies
• Supervises the activities of foreign banks
operating in the U.S.
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Chairman of the Board of Governors
• Advises the president on
economic policy
• Testifies in Congress
• Speaks for the Federal Reserve System
to the media
• May represent the U.S. in negotiations
with foreign governments on
economic matters
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Federal Open Market
Committee (FOMC)
• Meets eight times a year
• Consists of seven members of the Board of
Governors, the president of the Federal
Reserve Bank of New York and the presidents
of four other Federal Reserve banks
• Chairman of the Board of Governors is also
chair of FOMC
• Issues directives to the trading desk at the
Federal Reserve Bank of New York
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Federal Open Market Committee
(FMOC) Meeting
• Report by the manager of system open market
operations on foreign currency and domestic open
market operations and other related issues
• “Green Book” economic forecast
 Go-round – reports from all the regional banks
• Current monetary policy and domestic policy directive
 “Blue book” – research shared on topics such as
monetary policy and the foreign exchange market
• Presentation on relevant Congressional actions
• Public announcement about the outcome of
the meeting
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Chairman Runs the Show
• Spokesperson for the Fed and
negotiates with Congress and
the President
• Sets the agenda for meetings
• Speaks and votes first about
monetary policy
• Supervises professional economists
and advisers
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How Independent is the Fed?
• Instrument independence – ability of
Fed to set monetary policy
instruments
• Goal independence – ability to set
goals of monetary policy
• Fed is free from the pressures of
other government agencies
• Independent revenue - $18 billion
per year but returns money to the
treasury
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How Independent is the Fed?
• Structured by legislation from
Congress and accountable for its
actions
• Presidential influence
 Influence on Congress
 Appoints members
 Appoints chairman although terms
are not the same as the
President’s term
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European Central Bank
• Patterned after the Federal Reserve
• Central banks from each country play
similar role as Fed banks
• Executive Board


President, vice-president and four
other members
Eight year, nonrenewable terms
• Governing Council
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Differences
• National Central Banks control their own
budgets and the budget of the ECB
• Monetary operations are not centralized
• Does not supervise and regulate
financial institutions
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Governing Council
• Monthly meetings at ECB in
Frankfurt, Germany
• Twelve National Central Bank heads and
six Executive Board members
• Operates by consensus
• ECB announces the target rate and takes
questions from the media
• To stay at a manageable size as new
countries join, the Governing Council will
be on a system of rotation
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ECB Independence
•
•
•
•
Most independent in the world
Long terms
Determines own budget
Less goal independent

Price stability
• Charter cannot by changed by
legislation; only by revision of the
Maastricht Treaty
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Central Bank Behavior
• Theory of bureaucratic behavior—
objective is to maximize its own
welfare which is related to power
and prestige

Fight vigorously to preserve
autonomy

Avoid conflict with more powerful
groups
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Case for Independence
• Political pressure would impart an
inflationary bias to monetary policy
• Political business cycle
• Could be used to facilitate Treasury
financing of large budget deficits—
accommodation
• Too important to leave to politicians—the
principal-agent problem is worse for
politicians
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Case Against Independence
• Undemocratic
• Unaccountable
• Difficult to coordinate fiscal and
monetary policy
• Has not used its independence
successfully
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Summary
1. The Federal Reserve System was
created in 1913 to lessen bank
panics.
2. The structure of the Fed consists of
12 regional banks, 2800 commercial
banks
3. The Fed is a unified central bank
controlled by the Board of Governors,
especially the Board Chairman
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Summary
4. The Fed is more independent than
most US government agencies
5. The European Central Bank has a
similar structure to the Fed.
6. A world trend toward more
independence of central banks to produce
better monetary policy
7. The case for an independent Fed is that
it can take a long view and not respond to
short term problems of governments.
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